Three targets not one … the post-Budget default conundrum

More than 90 per cent of DC savers are in lifestyle strategies that are no longer suitable. Emma Wall finds little consensus on what should be done

So, none of us are going to have to buy an annuity. From next April, Britons will have more flexible access to their pension pots, allowing them to drawdown all of their savings in one lump sum at retirement; free to fritter it away on sheds, cruises and grand-children.

As soon as Chancellor George Osborne had uttered the words “no one will have to buy an annuity” in March’s Budget speech, the share price of life assurance companies tumbled.

While the Tories back-slapped one another on the success of the pensions revolution, the markets reacted to the reality of Osborne’s words; that the current retirement savings system is no longer equipped to deliver.

Whatever the exact statistics, from April 2015 it is safe to assume there will be a significant enough reduction in the number of UK pension savers buying an annuity to mean that investment strategies will have to change.

More than 90 per cent of DC funds currently follow a lifestyle investment strategy towards a predetermined retirement date; a system, which in less than a year’s time will be completely unsuitable.

“Following the reforms announced in the Budget, we believe lifestyle strategies will no longer meet the needs of the vast majority of members,” said AllianceBernstein managing director, pension strategies group, Tim Banks.

“Our survey of DC members shows that nearly three-quarters had either ‘no idea’ or only a ‘vague idea’ of the date they would retire. It is not unreasonable to assume that they are also unsure what they will do with their pension pot and clearly require a flexible solution to meet the demands of the modern working environment.”

While the Budget announcements are not likely to affect the investment process for the growth stages of DC schemes, defaults are currently targeting gilts for annuity purchase during the latter stages of membership.

Nest chief executive Tim Jones says the provider will be reviewing its approach in the consolidation phase to ensure how they manage members’ money in that phase best matches a member’s planned method of taking retirement benefits.

“Our over-riding concern is to act in our members’ best interests – that will be the lens through which we will consider any changes that may be needed,” he said.

For members retiring after next April the end game aim has to change. Retirement consultancy Mercer stresses that the new way schemes approach investing for retirement will depend entirely on fund size, other pension assets and non-pension assets – and expresses a hopeful view that the media attention on the Budget will help engage members in tailoring their own outcomes.

JLT says that fundamentals of the current mainstream approach to default fund construction are not going to change markedly – there will still be a growth stage and a pre-retirement stage, however, the composition of the pre-retirement stage will develop.

Whitehead adds: “A higher level of cash will be targeted, but members will also be looking to protect purchasing power, yield or income delivery with enhanced cash and Libor plus type funds.”

Schroders head of UK institutional business development group Neil Walton says the focus must remain income. He stresses that accumulating capital – while appropriate for the growth stage of pension saving – is only a stage in the journey.

“In the later stages of a member’s journey capital preservation will also become very important,” he said. “The mechanism by which a member takes an income is now a personal choice. This means that it will be difficult to have a single solution that fits everyone’s requirements. A solution that targets a sustainable level of income is likely to play a critical role for many people.”

According to Barclays Corporate & Employer Solutions head of investment proposition, Jonathan Parker the members and the market must wait for clarification.

Three roads

For now, we are playing a guessing game – the target for members retiring after next year is less clear and only time will tell which of the proposed new options is most popular.

“What is clear is that pension schemes will need to get much better at understanding the likely decisions that their members will take and members will need to be communicated with much more frequently so that they understand their options and make appropriate investment decisions,” he says. “All the evidence to date is that members do not feel well equipped to make such decisions and that their primary goal is to generate a sustainable, predictable income in retirement.”

Which means the one thing that is for certain, is education is key. While the risk of retirees splurging their lump sum in a Wolf of Wall Street style blow out is small, annuities – though restrictive – did ensure that the cash never ran out.

“We want our members to be able to access their retirement pots in ways that help them meet their aspirations and provide the flexibility they need in later life,” says Banks. “Changes to the ways in which consumers want to access their pension savings, and what they are allowed to do with them, are likely to influence how we manage their risks and invest their money. It will also affect what help and guidance we provide to members about the choices they need to make.”

Nest says it plans to consult widely to ensure that they are bringing the best ideas to bear on delivering appropriate solutions to their members. And in the meantime the website points members towards the Pensions Advisory Service, Money Advice Service and independent financial advisers.

The onus is on pension providers to inform members of these changes although Parker said that some providers do have the power to change lifestyle funds without member consent, although it is less likely to be the case with older policies. He urges members of these schemes to take action if they wish to change into an investment arrangement appropriate for their requirements.

Target date funds have made much of their flexibility and ability to respond quickly to changes, and Banks stresses that Alliance Bernstein sees an opportunity for these proactively managed solutions.

“Solutions that allow for quick and easy changes as well as early or late retirement and expect a dramatic shift toward strategies such as target date funds will play a much greater role in the future,” he said.

“The objective of any saver in a pension plan is to provide the best possible income in retirement. TDFs benefit savers by remaining robust to a wide range of possibilities rather than guess a specific outcome for any one individual.”

However, the flexibility that TDF fund managers have to act without the consent of members can be a double-edged sword. While the ability to act quickly is a bonus, transparency is key when communicating with members – and has been stressed as such by the regulator.

Mercer head of defined contribution Paul Macro agrees TDFs will be a big part of the future landscape, but which assets they need to move into will still depend on what the member expects to do at retirement.

“People will need different assets depending on what they do with their funds at retirement – such as gilts and bonds for annuities, cash or some inflation linked asset for a lump sum, or a lower growth fund for drawdown – much work is going on to get the right asset mix for these situations and much more sophisticated approaches than I have outlined will emerge soon,” says Macro. “But people will also want to use their funds for multiple purposes such as a combination of drawdown and annuity, so flexibility and being able to combine strategies will be crucial.”

15-year gilts no longer the target

Last year more than 350,000 annuities were sold by Association of British Insurance members in the UK and analysts predict this market will now drop by two thirds over the next 18 months.

JLT Employee Benefits senior consultant Dorian Whitehead believes there will be a noticeable reduction in the number of people who buy an annuity at retirement. In particular he predicts retirees with smaller pots will be converting their savings immediately into cash.

“We also believe that the market for impaired life annuities will shrink as the drawdown option will be more appealing to this group of the population,” he says.

But JLT do not expect the falloff will be as low as it is in other countries where greater flexibility already exists, such as the US and Australia as some pensioners with larger total retirement funds may buy an annuity to cover the basic costs of living, as kind of back-up plan.

According to research by Australian provider Challenger published in April 2012, just 4 per cent of retiring Australians purchase an immediate annuity, with 21 per cent deferred taking accessing their pension savings, 27 per cent invested the lump sum elsewhere and 32 per cent paid of their mortgage. The remainder was used to buy cars, help out relatives and spent on holidays.